RDP 2009-10: Global Relative Price Shocks: The Role of Macroeconomic Policies 7. Relative Prices and the Role of Policy

Although monetary policy may have had only a minor role in driving the trends in relative prices over the past decade, our simulations show that it is possible for monetary policy to have an effect on relative prices in the short to medium term. It is also possible that the decline in global risk premia up to 2007 as investors searched for yield was also driven, at least in part, by monetary policies globally, even though we assume it to be a separate shock in this paper. Although we do not formally explore the optimal policy responses to the shocks driving the large relative price movements that the world economy has experienced, it is worth discussing some of the principles that macroeconomic policies should follow in response to these forces.

The presence of nominal rigidities, affecting some wages and/or prices, and real rigidities, such as capital adjustment costs, make it possible for monetary policy to have some effect on relative prices, including the terms of trade and real exchange rates. In an economy with sticky wages or prices, an easing of monetary policy will result in prices that are more flexible rising faster than those that are more sticky. This leads to a temporary shift in demand towards the sticky-price sectors. As sticky prices gradually adjust, relative prices and output will eventually return to long-run equilibrium. In the meantime, given a temporary fall in real interest rates, demand for durable goods, for example, should expand faster than in other sectors. Accordingly, the prices of capital-intensive sectors should rise by more while real interest rates are low.

When and how monetary policy should respond to relative price movements will depend on the nature of the shocks driving these changes. If they are very temporary, there may be little if any time to respond given the lag with which monetary policy can take effect. If the shocks are more persistent (though still temporary), much of the literature would argue that there are circumstances under which it is optimal for policy-makers to essentially do nothing – that is, not to respond to the shocks driving relative prices and to tolerate the resulting deviation of inflation from a target for a short time so long as this does not jeopardise hitting the inflation target over the medium term. There are circumstances, however, when policy may want to actively respond so as to speed the transition to the new relative price equilibrium; along the way inflation may well deviate from target, so again, the monetary authorities will need to ensure that inflation remains anchored to the target over the medium term. Of course, in practice it is difficult for policy-makers to recognise in real time whether a shift in relative prices is being driven by temporary or permanent factors, nor can they be certain about the extent to which policy can successfully fine-tune a faster transition if required.

Aoki (2001) examines the optimal monetary policy responses to relative price changes in both a closed economy model and a small open economy model and draws similar conclusions to those presented here. The models are based around two sectors, one with flexible prices, the other with sticky prices. The main findings are that stabilising relative prices around their efficient level should be a goal of a central bank and that targeting inflation in the sticky-price sector is sufficient to achieve this goal. In an open economy context, Aoki argues that the central bank should target domestic inflation since imported prices are typically flexible. By targeting domestic inflation, the central bank can effectively keep the real exchange rate at its optimal level, which is desirable from a welfare perspective. The argument that central banks should try to stabilise relative prices around their efficient levels could be extended to a world with other distortions not resulting from nominal rigidities.

Benigno (2002) examines optimal policy in an open economy, sticky-price model. In a closed economy model, optimal monetary policy tends to be somewhat expansionary in order to offset the distortion implied by monopolistic competition. In an open economy setting, if monetary authorities behave non-cooperatively, there is another mechanism that works in the opposite direction. Each policy-maker aims to improve their terms of trade and to shift the burden of production to the other country by appreciating their currency in the presence of nominal rigidities. The incentive for such contractionary policy is greater the more open an economy and the more substitutable domestic and foreign goods are in consumption. Others, like Canzoneri and Henderson (1991), find a similar contractionary bias but for a different reason. In their one-shot, two-country game, tighter monetary policy in one country leads to a real depreciation and higher inflation for the other country. Hence, following a common shock that raises inflation in both economies, monetary authorities in both countries try to engineer a real exchange rate appreciation by tightening monetary policy. The result of this combined action by the two policy authorities in a non-cooperative Nash equilibrium is that monetary policy becomes excessively tight in both economies compared to an equilibrium when the policy actions in the two countries are coordinated.

While monetary policy can only have relatively temporary effects on relative prices^[10], fiscal policy can have more enduring effects. The use of fiscal instruments to address permanent changes in relative prices, however, is not without its problems and policy-makers need to take some care when using spending and taxing instruments to effect a change in relative prices. Should the shift in relative prices be the result of reduced competition in a particular market, or distortions due to fiscal policies abroad, there may be a case for a government to levy taxes or provide subsidies to offset the effect of these other distortions on relative prices. However, if relative prices are changing due to more fundamental factors, such as a shift in relative productivity levels, a fiscal authority working to offset the resulting shift in relative prices will lower welfare by distorting the allocation of resources.

There are other questions related to how a fiscal authority should deal with the boom in revenues that may result from a large terms of trade boost. Countries whose industries are highly concentrated in the production of a few commodities that may experience large increases in their prices will need to manage revenues carefully. Should the price of a particular commodity rise temporarily, it would be prudent of fiscal authorities to invest the windfall in another economy. This way, the fiscal authority, whose revenues may already be sensitive to the domestic economic cycle, can diversify its revenue risk; should commodity prices fall, along with the economy's real and nominal exchange rates, the domestic currency value of the government's investments overseas will rise as a result. Examples of this type of fund, known as sovereign wealth funds, include Chile's Economic and Social Stabilization Fund and Norway's Government Pension Fund Global (a continuation of the Petroleum Fund). Ideally, these funds would be invested in sectors not related to the sources of the shifts in the price of the commodity in question.

Footnote

Although monetary policy can have a more sustained (but not permanent) effect if it has some effect on the appetite for risk of investors. [10]